China starts new decade with inflation fight

HONG KONG (MarketWatch) -- We have heard many times this will be China s century, but the second decade could prove tougher than the first.

Last year's massive stimulus may have secured another year of 10% plus GDP growth but it came at a cost to the economy in terms of soaring property and food prices. When high prices make property unaffordable is one thing, but too high to be able to eat is much more serious.

China starts the New Year with curbing inflation priority number one, and after a 25 basis point rate hike on Boxing Day, all eyes are on further tightening.

This inflation fight comes at a time when Beijing is seeking to steer the economy from export dependence to more self sustaining domestic demand. So far, it looks only to have shifted the economy into a frenzy of domestic property speculation.

The experience told to me by one international manufacturer dealing with suppliers gives a flavor of the current business atmosphere in China.

A new problem had emerged scheduling supplier meetings, despite the chunky contracts on offer. The problem was these entrepreneurs were now too often pre-occupied with new property or hotel projects, often encouraged by state financing. Perhaps this is an economy rebalancing, but it looks like further evidence of an orchestrated property development mania.

Going by recent record prices for land sales in Shanghai and Beijing in December, enthusiasm for property appears unabated despite government cooling measures.

December inflation hit 5.1% year on year. The official line on all this remains no need to worry. On Boxing day, Premier Wen Jiabao was quoted to say "as it looks now, we are completely able to control the overall level of prices."

That might be beyond the government but it can be expected to try. Once the inflation genie has escaped the wider issue is inflation expectations. The move by Beijing local government in recent days to raise the minimum wage 20.8 % from January 960 yuan ($145) to 1,160 yuan may help to soften the impact of rising prices, but it is also likely to stoke inflation expectations.

The market will now be on the watch for another round of wage hikes.

Meanwhile, a consensus appears to forming that this time around inflation is not just a seasonal food spike as the chain of rising prices and higher wages spread. Now, for instance, higher wages for farm laborers go into the rising price of food.

Analysts are also grappling with China's growth pains. In a new strategy note, Nomura suggest China has now entered the 'Lewis turning point': the early stage of development where there would be unlimited supplies of labor from the subsistence economy, which means that the capitalist sector can expand without the need to raise wages. This all underscores the need for Beijing to rebalance the economy.

Nomura also notes that China remains reluctant to have any meaningful revaluation of the yuan to counter inflation and instead 'seems keener to lose competitiveness through higher wages than a higher currency.'

One way or another, this is likely to be a drag on China s manufacturing sector and corporate profits.

These issues are prompting analysts to ask if we are in for another difficult year for mainland equities. Shanghai A-shares were the third worst performing major index in 2010 ending down 14.3% for all its stimulus efforts.

One interpretation is insiders are not optimistic on corporate profitability or equities ability to act as an inflation hedge. Goldman Sachs, in its 2011 Equity outlook, comes across fairly guarded. "Inflation pressures and associated policy headwinds may hobble markets like China at the start of the year."

One clear policy headwind is the unknown degree to which interest rates will rise. The mainland government has been behind the curve on inflation and do not expect visibility on tightening and inflation to late 1H011, say Goldman.

Nomura say look to Australia to get some idea how far behind the curve Beijing is. There the central bank has raised interest rates seven times since the 2008. The upshot is interest rates will remain a key overhang.

Of course, inflation and higher interest rates are not bad for everyone. Many Chinese workers should be enjoying wage increases and savers will be pleased to get a higher return. There are also likely to be a few western manufacturers happier to be competing in an environment of China exporting inflation, rather than deflation.

It may still be China's century but not one where we can expect it will all be one-way traffic.